Trust-Owned Annuities

IRC Section 72 governs the income taxation of annuity contracts. IRC Section 72(u)(1) taxes the income on an annuity contract owned by a “non-natural” person by treating it as though it was received by the non-natural owner. If, however, a non-natural person is merely holding the contract as an “agent” for a natural person, the income on the contract will not be so treated. Unfortunately, neither the Internal Revenue Code nor the regulations explain when an agency arrangement will be deemed to exist.

For 2010, irrevocable trusts reach the highest income tax rate (35%) at $11,200 of taxable income. In comparison, married couples filing jointly and single taxpayers do not reach the 35% income tax rate until $357,700 of taxable income! Thus, wealthier individuals tend to invest in trusts for growth rather than for income. This is particularly true for credit shelter trusts (also known as family trusts and residuary trusts) where the surviving spouse neither needs nor wants current income, but wants to allow the trust assets to grow – estate tax free – for the benefit of children and grandchildren. If an annuity contract is to be used as a trust investment, the critical question to avoid current income taxation becomes whether the trust, a non-natural person, can be an agent for its natural person beneficiaries.

Single Beneficiary Trusts

In PLRs 9204010 and 9204014, the IRS determined that a trust was acting as an agent for a natural person when it purchased an annuity for the sole beneficiary of the trust. Under the terms of the trust, the trustee had discretion to pay income and corpus to the beneficiary until the beneficiary attains age 40, at which point the entire trust corpus (including the annuity contract) was to be distributed to the beneficiary. The IRS simply concluded that the trustee’s ownership of the annuity contract was nominal compared to that of the beneficiary and, consequently, the beneficiary was the beneficial owner of the annuity contract. The PLRs did not address what bearing, if any, there would be on the ruling if the beneficiary died prior to age 40 and the trust property passed to a contingent remainder beneficiary.

In PLRs 200449011, 200449013, 200449014, 200449015, 200449016 and 200449017, with almost identical facts, the IRS determined that the trust was acting as an agent for a natural person when it purchased an annuity contract for the sole benefit of the grantor’s grandchild. In those rulings, the annuity contracts were to be distributed in-kind. The PLRs did not address, however, what the tax consequences would be under IRC Section 72 if any distribution from the trusts were in cash.

Multiple Beneficiary Trusts

In PLR 9752035, the IRS determined, with no discussion, that a trust was acting as an agent for a natural person when it purchased an annuity contract. In PLR 9752035, there was a life income beneficiary (who was also the annuitant) and remaindermen. Although the outcome of PLR 9752035 was favorable, it provides little guidance as to when a trust is acting as an agent for a natural person.

Trust Distributions

IRC Section 72(e)(4)(C) provides, in part, that if an individual transfers an annuity contract without full and adequate consideration, the individual will be taxed on the amount in excess of the contract’s surrender value. However, in PLR 199905015 and PLR 9204014, the IRS ruled that IRC Section 72(e)(4)(C) does not apply when an annuity is transferred in-kind from a trust to the beneficiary. The trust beneficiary would simply become the owner of the annuity contract, would inherit its cost basis, and would continue to enjoy its tax-deferred status.

Other Section 72 Issues

Required Distributions. IRC Section 72(s) sets forth the required distribution rules which an annuity contract must satisfy upon the death of the holder of the annuity contract. Following is a summary of those rules:

  • If the holder dies after the annuity starting date, the remaining interest must be distributed at least as rapidly as the method of distributions being used at the date of the holder’s death.
  • Generally, if the holder dies before the annuity starting date, the entire interest must be distributed within 5 years of the holder’s death.
  • An exception to the 5-year rule allows a designated beneficiary to elect, within 1 year of the holder’s death, to take distribution of the proceeds over his/her life expectancy. A designated beneficiary is an individual named by the holder as the beneficiary of the annuity contract. A trust does not qualify as a designated beneficiary.
  • If the holder’s surviving spouse is the designated beneficiary, the surviving spouse has the ability to continue the decedent’s contract as though it were his/her own.

With a trust-owned annuity contract, the annuitant is defined to be the holder. Thus, it is the annuitant’s death that triggers a required distribution under IRC Section 72(s)(6). If, as is usual, the trust is the beneficiary of the contract, then the 5-year rule applies. Since a designated beneficiary must be an individual, the opportunity for a life expectancy pay-out appears to be unavailable. But under IRC Section 401(a)(9), which governs distributions from qualified retirement plans and IRAs, the beneficiaries of a properly designed trust which name trusts as beneficiaries (called a “see-through trust” by the IRS) will be treated as having been designated as the beneficiaries of the plan or IRA. Does the same hold true for trust-owned annuities, thereby allowing a life expectancy payout for annuities that name see-through trusts as the beneficiaries? Unfortunately, this issue has not yet been addressed by the courts or the IRS.

What if the irrevocable trust is a “grantor” trust for income tax purposes and the grantor and annuitant (normally the trust beneficiary) are not the same person? While not clear, arguably the grantor should be treated as the holder of the contract. If so, then it would be the grantor’s death (not the annuitant’s) that would determine when distributions from the contract must be made.

Penalty for Premature Distributions. IRC Section 72(q) imposes a 10% penalty tax on premature distributions from an annuity contract. Generally, the penalty tax applies to distributions to the “taxpayer” prior to attaining age 59 ½. If the annuity contract is owned by a trust, then who is the “taxpayer” for purposes of IRC Section 72(q)?

As discussed above, the annuitant is treated as the holder of a trust-owned annuity for purposes of the required distributions upon the death of the holder. Thus, it is logical to look at the annuitant for purposes of applying the age 59 1/2 exception for the premature distribution penalty. Assuming the annuitant’s age is not the relevant measure, then presumably it must be the beneficiary’s or beneficiaries’ age. If so, must all the beneficiaries be over age 59 1/2 for the exception to apply? Moreover, if the irrevocable trust is a grantor trust, is the penalty then based on the grantor’s age? Unfortunately, each of these questions remains unanswered. To avoid these issues, consideration should be given to distributing the contract outright to the beneficiary before the date withdrawals are to begin.

Designing the Trust

Keeping in mind that the PLRs cited above are only binding on taxpayers who requested the ruling, they do suggest that an annuity contract acquired by an irrevocable trust or credit shelter trust can provide tax deferral. But great care must be exercised to make sure that both the trust and annuity contract are properly structured. Consider these factors when setting up a trust-owned annuity:

  • The trust agreement should not require its assets be invested in income-producing property.
  • The trust agreement should specifically authorize the trustee to invest in an annuity contract.
  • The trust agreement should specifically allow distribution of the annuity contract in-kind to avoid adverse income tax consequences. If separate contracts are established for each trust beneficiary, with each beneficiary named as the annuitant for his or her respective contract, the in-kind distribution of the contract to the beneficiary-annuitant should be a non-taxable event.
  • To avoid gift taxes, the trust should purchase the annuity contract directly.
  • The trust should be the owner and beneficiary of the annuity contract.
  • If the grantor of the trust is named the annuitant, his or her death will likely trigger a complete and taxable liquidation of the contract within five years.
  • If the annuitant were to die while the annuity contract was still held in trust, the contract will likely have to be liquidated in five years. Thus, consideration should be given to distributing the annuity contract to the beneficiary-annuitant before his or her death. By doing so, the beneficiary-annuitant, as the new owner, will continue to enjoy all of the contract’s benefits and guarantees, and can name a new designated beneficiary.
  • Avoid the 10% early distribution penalty when possible.
  • The named annuitant should never be changed. Otherwise, the contract must be liquidated within 5 years.

Although trust-owned annuities involve a significant degree of complexity and uncertainty, they can be extremely beneficial. This is particularly so for credit shelter trusts where it’s possible to pass on an inheritance and not an income tax bill.